© University of London 2017
UL17/0190 Page 1 of 4 D0

~~FN1024_ZA_2016_d0

This paper is not to be removed from the Examination Halls



UNIVERSITY OF LONDON FN1024 ZA


BSc degrees and Diplomas for Graduates in Economics, Management, Finance
and the Social Sciences, the Diplomas in Economics and Social Sciences


Principles of Banking and Finance


Tuesday, 9 May 2017 : 10:00 to 13:00


Candidates should answer FOUR of the following EIGHT questions: ONE from Section
A, ONE from Section B and TWO further questions from either section. All questions
carry equal marks.

A calculator may be used when answering questions on this paper and it must comply
in all respects with the specification given with your Admission Notice. The make and
type of machine must be clearly stated on the front cover of the answer book.












PLEASE TURN OVER

© University of London 2017
UL17/0190 Page 2 of 4 D0


SECTION A

Answer one question and no more than two further questions from this section.

1. (a) Explain the process of securitisation and identify the advantages to a financial institution in
securitising its assets. (10 marks)

(b) Explain the main characteristics of the 2007/8 sub-prime mortgage crisis. (15 marks)


2. (a) How does adverse selection influence the lending decisions of banks? (7 marks)

(b) Discuss how to reduce/solve the problems arising from moral hazard in lending.
(13 marks)

(c) Explain why loan contracts do not suffer from problems of free-riding on information
compared to bonds.
(5 marks)


3. (a) Discuss the arguments for and against bank regulation. (13 marks)

(b) Explain the differences between market-based and bank-based financial systems.
(12 marks)


4. (a) Distinguish between valuation, allocative and informational efficiency in relation to financial
markets. Explain why allocative efficiency depends upon the existence of valuation and
informational efficiency. (10 marks)

(b) Explain the empirical evidence on market underreaction in the context of weak and semi-
strong form efficiency.
(15 marks)




© University of London 2017
UL17/0190 Page 3 of 4 D0

SECTION B

Answer one question and no more than two further questions from this section.

5. A firm is considering investing in the following two mutually exclusive projects:

Year Alpine Beeline
0 -252000 -372000
1 125000 100000
2 140000 140000
3 -100000 125000
4 170000 125000

(a) If the opportunity cost of capital is 9%, calculate the net present value (NPV) for each
project. (4 marks)

(b) Calculate the net present value for each project for discount rates of 12% and 14%. Draw a
diagram of NPV against discount rates of 9%, 12% and 14% and identify the approximate
internal rate of return (IRR) for each project (you may give your answer as a range e.g. 5% to
5.5%). (7 marks)

(c) Based on your results for (a) and (b) which investment project(s) should the company invest
in? Explain your decision. (5 marks)

(d) Explain the payback method of investment appraisal and discuss its advantages and
disadvantages. (5 marks)

(e) Explain why the NPV decision rule is consistent with the objective of the firm to maximise
shareholder wealth. (4 marks)



6. (a) Explain the differences between reinvestment and refinancing risk giving examples and
identify which is likely to be more common for a bank. (5 marks)

(b) Explain how a bank can use income gap analysis to manage interest rate risk. Critically
discuss the problems associated with income gap analysis. (8 marks)

(c) Consider the following balance sheet of Bank Gamma:

Assets (£) Duration Liabilities (£) Duration
Variable-rate
mortgages 260 8.1 Money market deposits 350 1.9
Fixed-rate
mortgages 140 5.1 Savings deposits 280 2.3
Commercial
loans 560 3.5 Variable-rate CD (> 1 year) 210 3.1
Physical capital 230 Equity 350
Total 1190 Total 1190

What will be the change in net interest income at the year-end if interest rates fall by 1 per cent,
from 5 to 4 per cent? Explain using income gap analysis.
Question continues on next page
© University of London 2017
UL17/0190 Page 4 of 4 D0

(Use the following assumptions on the runoff of cash flows: fixed-rate mortgages repaid during
the year: 20 per cent; proportion of savings deposits and variable rate CD that are rate-
sensitive: 20 per cent). (4 marks)

(d) Calculate the duration gap for Bank Gamma? (4 marks)

(e) Explain why duration gap is likely to be positive for a bank. (4 marks)


7. (a) Consider the following stocks:

Stock X is expected to pay a dividend of £3 for the next two years and then £4 forever;

Stock Y is expected to pay a dividend of £0.8, followed by £1.20 in year 2 then £1.40 in year 3
with dividend growth expected to be 3% per annum thereafter.

If the required return on similar equities is 7%, calculate the price of each stock. (6 marks)

(b) Discuss the issues with estimating future cash flows for a stock, government bond and
corporate bond. (6 marks)

(c) Formally derive and discuss the dividend discount model used for the valuation of common
stocks. (9 marks)

(d) Describe the Gordon growth model and identify the types of stocks it is best used to value.
(4 marks)


8. (a) Briefly explain each of the following terms:

(i) efficient frontier
(ii) feasible region
(iii) security market line
(iv) market risk premium
(8 marks)

(b) Explain why, under the CAPM framework, the standard deviation of an asset’s returns is not
a good measure of risk. (4 marks)

(c) Demonstrate how the capital market line can be identified by the introduction of a risk-free
asset. (8 marks)

(d) Discuss the problems with empirically testing the Capital Asset Pricing Model. (5 marks)







END OF PAPER


© University of London 2017
UL17/0191 Page 1 of 4 D0

~~FN1024_ZB_2016_d0

This paper is not to be removed from the Examination Halls



UNIVERSITY OF LONDON FN1024 ZB


BSc degrees and Diplomas for Graduates in Economics, Management, Finance
and the Social Sciences, the Diplomas in Economics and Social Sciences


Principles of Banking and Finance


Tuesday, 9 May 2017 : 10:00 to 13:00


Candidates should answer FOUR of the following EIGHT questions: ONE from Section
A, ONE from Section B and TWO further questions from either section. All questions
carry equal marks.

A calculator may be used when answering questions on this paper and it must comply
in all respects with the specification given with your Admission Notice. The make and
type of machine must be clearly stated on the front cover of the answer book.












PLEASE TURN OVER
© University of London 2017
UL17/0191 Page 2 of 4 D0


SECTION A

Answer one question and no more than two further questions from this section.

1. (a) Explain the process of securitisation and identify the advantages to a financial institution in
securitising its assets. (10 marks)

(b) With reference to examples, discuss the characteristics and consequences of financial
bubbles in markets. (15 marks)


2. (a) How does moral hazard influence the lending decisions of banks? (7 marks)

(b) Discuss how to reduce/solve the problems arising from adverse selection in the lending
process. (13 marks)

(c) Explain why loan contracts do not suffer from free-riding problems in information production
compared to bonds. (5 marks)


3. (a) Discuss the main changes to capital regulation introduced by Basel 3. (15 marks)

(b) Explain the key features of the safety net in the regulatory system for banks. Discuss the
problems caused by this safety net and the solutions to these problems. (10 marks)


4. (a) Distinguish between valuation, allocative and informational efficiency in relation to financial
markets. Explain why allocative efficiency depends upon the existence of valuation and
informational efficiency. (10 marks)

(b) Explain the empirical evidence on market over-reaction in the context of weak and semi-
strong form efficiency. (15 marks)






© University of London 2017
UL17/0191 Page 3 of 4 D0

SECTION B

Answer one question and no more than two further questions from this section.

5. A firm is considering investing in the following two mutually exclusive projects:

Year Yeti Zylo
0 -260000 -350000
1 120000 100000
2 140000 130000
3 -100000 125000
4 170000 125000

(a) If the opportunity cost of capital is 9%, calculate the net present value (NPV) for each
projects. (4 marks)

(b) Calculate the net present value for each project for discount rates of 12% and 14%. Draw a
diagram of NPV against discount rates of 9%, 12% and 14% and identify the approximate
internal rate of return (IRR) for each project (you may give your answer as a range e.g. 5% to
5.5%). (7 marks)

(c) Based on your results for (a) and (b) which investment project(s) should the company invest
in? Explain your decision. (4 marks)

(d) Critically assess the usefulness of the internal rate of return criterion for investment
appraisal. (6 marks)

(e) Explain why the additivity property of NPV is useful when selecting investment projects
where funds are limited. (4 marks)



6. (a) Compare income gap analysis with duration gap analysis as techniques for managing
interest rate risk for a bank. (9 marks)

(b) Consider the following balance sheet of Bank Leppa:

Assets ($) Duration Liabilities ($) Duration
Variable-rate
mortgages 250 7.5 Money market deposits 300 1.9
Fixed-rate
mortgages 120 4.1 Savings deposits 250 2.2
Commercial
loans 500 4.5 Variable-rate CD (> 1 year) 210 3.0
Physical capital 200 Equity 310
Total 1070 Total 1070

What will be the change in net interest income at the year-end if interest rates rise by 1 per
cent, from 3 to 4 per cent? Explain using income gap analysis.
Question continues on next page



© University of London 2017
UL17/0191 Page 4 of 4 D0

(Use the following assumptions on the runoff of cash flows: fixed-rate mortgages repaid during
the year: 20 per cent; proportion of savings deposits and variable rate CD that are rate-
sensitive: 20 per cent). (4 marks)

(c) Calculate the duration gap for Bank Leppa? (4 marks)

(d) What is the estimated change in the value of equity (in $s) for Bank Leppa if interest rates
increase by 1% from 3 to 4%? (4 marks)

(e) Explain why duration gap is likely to be positive for a bank. (4 marks)


7. (a) Consider the following stocks:

Stock A is expected to pay a dividend of $2.50 for the next two years and then $4 forever;

Stock B is expected to pay a dividend of $0.9, followed by $1.20 in year 2 then $1.50 in year 3
with dividend growth expected to be 4% per annum thereafter.

If the required return on similar equities is 6%, calculate the price of each stock. (6 marks)

(b) Discuss the issues with estimating future cash flows for a stock, government bond and
corporate bond. (6 marks)

(c) Explain why capital gains is not included in the dividend discount formula for the valuation of
a stock. (5 marks)

(d) Explain Macaulay duration and describe the main characteristics of Macaulay duration in
relation to bonds. (8 marks)



8. (a) Briefly explain each of the following terms:

(i) unsystematic (unique) risk
(ii) minimum risk portfolio
(iii) capital market line
(iv) market risk premium
(8 marks)

(b) Explain why, under the CAPM framework, the standard deviation of an asset’s returns is not
a good measure of risk. (4 marks)

(c) Derive, using two fund separation, the capital market line. (8 marks)

(d) Explain whether a stock that sits above the security market line is undervalued or
overvalued. Explain how this under or over valuation is likely to be corrected. (5 marks)




END OF PAPER

Examiners’ commentaries 2017
Examiners’ commentaries 2017
FN1024 Principles of banking and finance
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2016–17. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading
references
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
di↵erent editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.
General remarks
Learning outcomes
At the end of the course and having completed the Essential reading and activities you should:
• discuss why financial systems exist, and how they are structured
• explain why the relative importance of financial intermediaries and financial markets is
di↵erent around the world, and how bank-based systems di↵er from market-based systems
• understand why financial intermediaries exist, and discuss the role of transaction costs and
information asymmetry theories in providing an economic justification
• explain why banks need regulation, and illustrate the key reasons for and against the
regulation of banking systems
• discuss the main types of risks faced by banks, and use the main techniques employed by
banks to manage their risks
• explain how to value real assets and financial assets, and use the key capital budgeting
techniques (Net Present Value and Internal Rate of Return)
• explain how to value financial assets (bonds and stocks)
• understand how risk a↵ects the return of a risky asset, and hence how risk a↵ects the value
of the asset in equilibrium under the fundamental asset pricing paradigms (Capital Asset
Pricing Model and Asset Pricing Theory)
• discuss whether stock prices reflect all available information, and evaluate the empirical
evidence on informational eciency in financial markets.
1
FN1024 Principles of banking and finance
Planning your time in the examination
From the allocation of marks, you should be able to identify the importance and weighting of each
part of the question. Therefore, you should devote an appropriate amount of time to each part
related to the marks awarded.
What are the topics under examination?
The FN1024 Principles of banking and finance examination paper tests your understanding of
a wide range of concepts and techniques in the banking and finance areas. Therefore, you are
expected to demonstrate numerical competence as well as a thoughtful and clear writing style in the
discursive parts of each question.
All the questions asked in the examination are designed to test topics covered in the syllabus as
presented in the Regulations; the subject guide provides a framework for covering the syllabus and
directs you to the Essential reading. You are reminded that the examination for this course may test
any aspect of the syllabus.
What are the examiners looking for?
This is a foundation course and you are expected to demonstrate your knowledge and understanding
of key concepts/terms in banking and finance.
Moreover, you are expected to demonstrate your knowledge of the relevant technical terminology.
Finally, you are encouraged to demonstrate your ability to identify links between concepts presented
in di↵erent chapters of the syllabus/subject guide. In essay questions, in addition to depth of
knowledge of the subject matter, the examiners are looking for your ability to discuss and evaluate
arguments and to relate knowledge to the question asked, as opposed to simple repetition of factual
information on a particular topic. One way of helping to ensure that you have a clear,
well-structured and relevant argument is to spend a few minutes organising your answer before you
begin writing, and by trying not to fit a standard answer to the question.
Please note that since 2010 examination marks have not generally been allocated to individual
points made in the answer. This is particularly relevant to Section A questions but also to the parts
of Section B questions where you have to explain a concept. Instead, the examiners will be looking
at the answer as a whole when allocating a mark. The examiners will be looking for evidence of an
overall understanding of the concept/issue being examined. Demonstrating your understanding can
come from providing relevant factual information, relevant examples and showing how the concept
relates to other concepts in the syllabus. This change in the approach to marking will reinforce the
point made in the paragraph above that simple repetition of material from the subject guide is
unlikely to be rewarded with a high mark.
Key steps to improvement
While some of the questions might appear to be technical, most of the marks are awarded for
providing the economic reasoning and explanations. The examiners therefore recommend focusing
on both the economic reasoning and some of the techniques/tools as you work with the subject
guide. Note that in numerical questions alternative hypotheses are equally acceptable if you have
been consistent in the di↵erent parts of the question: in these cases the examiners are flexible in the
allocation of marks.
2
Examiners’ commentaries 2017
Examination revision strategy
Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons, but one particular failing is ‘question
spotting’, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.
We recognise that candidates might not cover all topics in the syllabus in the same depth, but you
need to be aware that examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.
The syllabus can be found in the Course information sheet available on the VLE. You should read
the syllabus carefully and ensure that you cover sucient material in preparation for the
examination. Examiners will vary the topics and questions from year to year and may well set
questions that have not appeared in past papers. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be helpful during your revision,
you cannot assume that topics or specific questions that have come up in past examinations will
occur again.
If you rely on a question-spotting strategy, it is likely you will find yourself in diculties
when you sit the examination. We strongly advise you not to adopt this strategy.
3
FN1024 Principles of banking and finance
Examiners’ commentaries 2017
FN1024 Principles of banking and finance
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2016–17. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading
references
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
di↵erent editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.
Comments on specific questions – Zone A
Candidates should answer FOUR of the following EIGHT questions: ONE from Section A, ONE
from Section B and TWO further questions from either section. All questions carry equal marks.
Section A
Answer one question and no more than two further questions from this section.
Question 1
(a) Explain the process of securitisation and identify the advantages to a financial
institution in securitising its assets.
(10 marks)
Reading for this question
See subject guide, Chapter 3, pages 56–7.
Approaching the question
This question part requires two things: an explanation of the process of securitisation and
the identification of reasons why a financial institution such as a bank securitises its assets.
Many answers simply focused on an explanation of the process and did not cover advantages.
Securitisation is the process of transforming illiquid financial assets (such as loans and
mortgages) into marketable securities. Typically, this involves packaging illiquid loans into
bundles and then passing these on to a third party (special purpose vehicle (SPV)). The
SPV then manages the securitisation by issuing new (loan backed) securities to investors.
The original loans continue to earn interest which is typically passed through to the SPV to
4
Examiners’ commentaries 2017
pay the interest/capital on the issued securities. The SPV will pass the proceeds from the
sale of the securities back to the bank as cash.
In engaging in this process, the bank has therefore transformed illiquid loans into cash. This
allows it to manage liquidity risk over the medium/long term. It can also be used to remove
assets that have a high-risk weighting into assets with a lower risk weighting to help manage
its capital requirement.
Better answers would also identify the risks with securitisation.
(b) Explain the main characteristics of the 2007/8 sub-prime mortgage crisis.
(15 marks)
Reading for this question
See subject guide, Chapter 3, pages 56–7.
Approaching the question
One way to begin answering this question part is to explain that over the period prior to
2007 structured credit markets experienced a rapid growth under benign conditions.
Investors showed a high-risk appetite that stimulated further development by financial
institutions of techniques for unbundling and distributing risks through financial markets.
This led to a marked expansion of the so-called sub-prime mortgage market.
In 2005 and 2006, the competition among the sub-prime originators intensified. To maintain
volumes and/or increase market share, originators introduced product innovations such as
teaser rates. At the same time, there was an apparent weakening of lending standards.
Loans were made with increasingly high loan-to-value ratios and often without full
documentation. Most originators sold the loans to larger banks, who in turn securitised
them and sold them to end-investors.
As interest rates increased and house prices fell rapidly in the U.S. in 2006 there was an
increase in mortgage defaults, particularly among sub-prime borrowers (especially for those
who moved o↵ teaser interest rates to higher rates). These mortgage defaults led to a
decline in the quality of securitised debt leading to a fall in value of this debt leading to
spread of the problem outside of sub-prime originating banks.
Better answers would tell a coherent ‘story’ of the causes of the crisis relating the di↵erent
elements together. Weaker answers will simply list the characteristics of the crisis.
Question 2
(a) How does adverse selection influence the lending decisions of banks?
(7 marks)
Reading for this question
See subject guide, Chapter 4, pages 73–4.
Approaching the question
Adverse selection is a problem created by asymmetric information. The existence of
asymmetric information means that lenders will lend at a rate of interest reflecting average
risk (as they cannot distinguish between good and bad risks).
This drives many good-risk borrowers out of the market leaving mainly poor risks. Hence
the borrowers who are more likely to want to borrow are poor risks. As a consequence,
lenders may decide not to lend.
Better answers will give more detail on how the decision to lend at rates of interest
reflecting average risk will lead to adverse selection. However, the discussion should be in
the context of lending decisions and not second-hand car purchase decisions.
5
FN1024 Principles of banking and finance
(b) Discuss how to reduce/solve the problems arising from moral hazard in lending.
(13 marks)
Reading for this question
See subject guide, Chapter 4, pages 79–80.
Approaching the question
A good answer would first define moral hazard, i.e. the risk created after the loan is made
because the borrower may use the loan for a riskier proposition than promised, thus
increasing the risk of default. It is a consequence of asymmetric information.
Solutions include:
1. Making debt contract incentive-compatible (i.e. align the incentives of borrowers and
lenders).
2. Monitoring and enforcement of restrictive covenants. Discussion of the types of possible
covenants and relevant examples needed.
3. Financial intermediaries. Problems arising from the use of covenants. Mechanisms used
by financial intermediaries to solve the incentive problem and the free-rider problem.
4. Use of screening and monitoring, favoured by the existence of established long-term
relationships to overcome moral hazard.
Better answers would explain in more detail how these solutions impact on moral hazard.
(c) Explain why loan contracts do not su↵er from problems of free-riding on
information compared to bonds.
(5 marks)
Reading for this question
See subject guide, Chapter 4, page 80.
Approaching the question
A good answer would refer to the fact that bank loans are private securities, not traded in
the open financial market.
Therefore, investors are not able to observe the bank and bid up the price of the loan to the
point where the bank makes no profit on the production of information.
Bonds in contrast are tradeable therefore bonds su↵er from free-riding.
Better answers would explain that as a consequence of lending through non-traded loans
banks have the incentive to devote sucient resources to solving adverse selection/moral
hazard problems because no other investors can extract benefits from this. Hence the bank
gets all the benefits.
Question 3
(a) Discuss the arguments for and against bank regulation.
(13 marks)
Reading for this question
See subject guide, Chapter 5, pages 92–6.
6
Examiners’ commentaries 2017
Approaching the question
The key arguments in favour include:
1. The fragility of banks – mainly due to their provision of liquidity to the financial system
(i.e. vulnerability to runs). A source of mitigation of fragility is the role of banks in
screening and monitoring borrowers who cannot obtain direct finance from financial
markets.
2. Systemic risk – the contagion e↵ect exacerbated by asymmetric information.
3. Depositor protection.
The main arguments against are:
1. Cost.
2. Complexity – creates opportunities for arbitrage which can lead to unintended
consequences.
3. Moral hazard.
4. Increases barriers to entry – less competition.
Better answers would identify that systemic risk is the most important reason to justify
prudential regulation of banks. So regulators are willing to accept the costs cited above in
order to get the main benefit of reduced systemic risk.
(b) Explain the di↵erences between market-based and bank-based financial systems.
(12 marks)
Reading for this question
See subject guide, Chapter 3, pages 50–3.
Approaching the question
A good answer would explain that essentially, in market-based systems (U.S. and U.K.) in
contrast to bank-based financial systems (Germany and Japan), the financial markets play a
greater role in providing finance to firms – the relationship between banks and firms is not
close and there is a lower level of integration between bank and non-bank financial services.
A better answer to this question would explain the following points in their discussion of the
di↵erences between the two types of system.
1. The proportion of gross financial assets owned by pension funds is higher in
market-based systems.
2. Equity is a more important component of households’ asset portfolios in market-based
systems.
3. Moral hazard should be lower in bank-based financial systems.
4. There is a trend towards market-based systems suggesting their superiority in terms of
capital allocation.
Question 4
(a) Distinguish between valuation, allocative and informational eciency in relation
to financial markets. Explain why allocative eciency depends upon the
existence of valuation and informational eciency.
(10 marks)
Reading for this question
See subject guide, Chapter 9, pages 184–5.
7
FN1024 Principles of banking and finance
Approaching the question
Note this question part has two elements: first, distinguishing between di↵erent kinds of
eciency in financial markets and, second, explaining why allocative eciency depends
upon the existence of the other two types. Better answers will cover both elements.
A financial market is referred to as informational ecient when security prices fully reflect
all available information.
Informational eciency is a more specific form of the general valuation eciency, which
refers to whether the prices of the securities traded on a market reflect the true fundamental
(also termed intrinsic, or fair) value of the securities. Under valuation eciency, all prices
are always correct, and reflect market fundamentals. Therefore, the market price of a
security is the fair price, and has to be equal to the expected cash-flows from the security
using all relevant information.
Informational eciency is a more specific form of eciency than valuation eciency,
because it assumes that expectations are optimal forecasts using all available information,
but not that market prices reflect the fair value.
Valuation eciency and informational eciency are conditions for the achievement of the
most general eciency condition of financial markets: allocative eciency. This refers to
whether a market allocates productive resources to the most productive investments in
performing its main function of channelling funds from saver–lenders to spender–borrowers.
This requires asset prices to reflect accurately the discounted stream of future cash-flows the
asset is expected to generate over its existence. The price of an asset then acts as a signal
directing resources from savers into the firm securities yielding the highest returns and from
firms into the real assets yielding the highest returns.
(b) Explain the empirical evidence on market under-reaction in the context of weak
and semi-strong form eciency.
(15 marks)
Reading for this question
See subject guide, Chapter 9, page 195.
Approaching the question
Evidence on market under-reaction constitutes an anomaly related to earnings
announcements. Although empirical evidence generally confirms rapid adjustment to new
information (as shown in the evidence in favour of the semi-strong form eciency), recent
evidence shows that stock prices do not instantaneously adjust.
A definition of under-reaction should be provided: under-reaction to earnings
announcements means that stock prices do not fully incorporate the new information
embodied in the unexpected earnings announcement.
Answers should then examine the empirical evidence that shows that adjustment to extreme
bad news takes several months: there is a market over-reaction and subsequent gradual
adjustment (see for example the evidence in Ball and Brown (1968), then confirmed by
Bernard and Thomas (1989)).
Better answers will describe the methodology and findings of the study by Bernard and
Thomas (1989). They calculate the Cumulative Abnormal Returns (CAR) for 10 portfolios
with di↵erent levels of unexpected good or bad earnings over the years 1974–86. CARs are
measured for the pre- and post-announcement period. Portfolio 10 contains the 10 per cent
of the stocks with the highest earnings performance, portfolio 1 the lowest 10 per cent.
Looking at Bernard and Thomas (1989), portfolio 10 outperformed portfolio 1 in the two
months following the announcement, and the di↵erence in the excess returns has been equal
to +4 per cent. Prices of good-news stocks continue to rise in the two months after the
earnings announcement, whereas prices of bad-news stocks continue to fall. Investors thus
can get an excess return in the short term by buying good-news stocks and selling bad-news
stocks. Such a trading strategy is known as a momentum strategy. The possibility of
8
Examiners’ commentaries 2017
profitably implementing a momentum strategy in such a framework is inconsistent with
semi-strong-form eciency.
Excellent answers would be expected to make the link with the empirical evidence on
under-reaction existing at a di↵erent level of informational eciency – the weak-form
eciency (see results in Jegadeesh and Titman (1993)). This evidence suggests buying past
winner stocks and selling past losers to get excess returns. Again, this evidence suggests
excess returns associated with a momentum strategy, but this evidence is inconsistent with
the weak-form eciency (not the semi-strong form) because the strategy is based on
historical prices only.
Section B
Answer one question and no more than two further questions from this section.
Question 5
A firm is considering investing in the following two mutually exclusive projects:
Year Alpine Beeline
0 252000 372000
1 125000 100000
2 140000 140000
3 100000 125000
4 170000 125000
(a) If the opportunity cost of capital is 9%, calculate the net present value (NPV)
for each project.
(4 marks)
(b) Calculate the net present value for each project for discount rates of 12% and
14%. Draw a diagram of NPV against discount rates of 9%, 12% and 14% and
identify the approximate internal rate of return (IRR) for each project (you
may give your answer as a range e.g. 5% to 5.5%).
(7 marks)
(c) Based on your results for (a) and (b) which investment project(s) should the
company invest in? Explain your decision.
(5 marks)
(d) Explain the payback method of investment appraisal and discuss its advantages
and disadvantages.
(5 marks)
(e) Explain why the NPV decision rule is consistent with the objective of the firm
to maximise shareholder wealth.
(4 marks)
Reading for this question
The reading for all parts of this question can be found in the subject guide, Chapter 7, pages
142–9.
9
FN1024 Principles of banking and finance
Approaching the question
(a) We have:
Alpine, Cn (1 + i)n Cn/(1 + i)n Beeline, Cn Cn/(1 + i)n
252000 1 252000 372000 372000
125000 0.9174 114678.89 100000 91743.11
140000 0.8416 117835.19 140000 117835.19
100000 0.7721 77218.34 125000 96522.93
170000 0.7084 120432.28 125000 88553.15
NPV 23728.03 22654.40
(b) We have:
Alpine, Cn (1 + 0.12)n Cn/(1 + 0.12)n Beeline, Cn Cn/(1 + 0.12)n
252000 1 252000 372000 372000
125000 0.8928 111607.14 100000 89285.71
140000 0.7971 111607.14 140000 111607.14
100000 0.7117 71178.02 125000 88972.53
170000 0.6355 108038.07 125000 79439.75
NPV 8074.33 2694.85
Alpine, Cn (1 + 0.14)n Cn/(1 + 0.14)n Beeline, Cn Cn/(1 + 0.14)n
252000 1 252000 372000 372000
125000 0.8771 109649.12 100000 87719.29
140000 0.7694 107725.45 140000 107725.45
100000 0.6749 67497.15 125000 84371.43
170000 0.5920 100653.64 125000 74010.03
NPV 1468.92 18173.77
I.e. IRR for Alpine ⇡ 13.9% and IRR for Beeline ⇡ 11.6%.

-25000
-20000
-15000
-10000
-5000
0
5000
10000
15000
20000
25000
30000
9 12 14
Chart Title
Series1 Series2
(c) As the projects are mutually exclusive we can only choose one. NPV is highest for Alpine at
cost of capital (9%). Also, supported by higher IRR for Alpine.
(d) The payback method identifies how quickly project cash-flows pay back the initial
investment.
The main disadvantages are:
• does not take into account the time value of money
• ignores cash-flows after the payback point (as in the example above).
The main advantages are:
• simple to calculate and understand
10
Examiners’ commentaries 2017
• useful if firm capital constrained
• focuses on near cash-flows, hence accounts for risk in a simple way.
(e) The value of a company is made up of the value of its assets + the NPV of current projects.
However, this will only maximise shareholder wealth if the NPV is positive, at a cost of
capital that reflects the required rate of return demanded from shareholders.
As the NPV rule identifies the projects generating wealth in today’s value terms, selection of
those projects will generate additional wealth for the company and hence shareholders.
Question 6
(a) Explain the di↵erences between reinvestment and refinancing risk giving
examples and identify which is likely to be more common for a bank.
(5 marks)
Reading for this question
See subject guide, Chapter 6, pages 117–8.
Approaching the question
Refinancing risk: the risk that the cost of re-borrowing funds will be higher than the returns
earned on asset investments, in the presence of longer-term assets relative to liabilities.
Reinvesment risk: the risk that returns on funds to be reinvested will be lower than the cost
of funds, when the bank holds shorter-term assets relative to liabilities.
Examples of each are required.
Banks more likely to face refinancing risk where they may lend out at fixed rates but have
to refinance at higher cost. Banks tend to have more floating rate liabilities than assets
therefore face greater refinancing risk.
(b) Explain how a bank can use income gap analysis to manage interest rate risk.
Critically discuss the problems associated with income gap analysis.
(8 marks)
Reading for this question
See subject guide, Chapter 6, pages 125–7.
Approaching the question
The basic intuition is that under the income gap analysis (maturity approach), banks report
the gap in each maturity bucket, calculated as the di↵erence between rate-sensitive assets
(RSA) and rate-sensitive liabilities (RSL) on their balance sheets. Candidates should then
provide the formula for the calculation of the gap:
GAP = RSA RSL.
Answers should clarify that a positive GAP implies sensitive assets > sensitive liabilities.
They should also illustrate the consequences of a change in interest rates in such a situation:
the rise in interest rates will cause a bank to have interest revenue rising faster than interest
costs; thus, the net interest margin and income will increase. The decline in interest rates
will decrease asset returns faster than liability costs; as a consequence, the net interest
margin and income will decrease.
Answers should then make clear the link between the gap measure and its use in the
management of interest rate risk. Banks’ managers can calculate the income exposure to
changes in interest rates in di↵erent maturity buckets, by multiplying GAP times the change
in the interest rate:
I = GAP⇥i
11
FN1024 Principles of banking and finance
where I = change in the banks’ income; i = change in interest rate.
Finally, answers should explain the three main problems associated with income gap
analysis:
• It ignores market value e↵ects of interest rates changes.
• Even rate-insensitive assets and liabilities (whose interest rates are not re-priced)
actually have a component that is rate sensitive (i.e. a run-o↵ cash-flow). Better answers
will give examples of these. Banks’ managers can deal with this problem by identifying
for each asset and liability the estimated run-o↵ cash-flow, to be added to the value of
the rate-sensitive assets and liabilities.
• It ignores the e↵ects of the changes in interest rates on o↵-balance sheet instruments.
(c) Consider the following balance sheet of Bank Gamma:
Assets (£) Duration Liabilities (£) Duration
Variable-rate
mortgages 260 8.1 Money market deposits 350 1.9
Fixed-rate
mortgages 140 5.1 Savings deposits 280 2.3
Commercial
loans 560 3.5 Variable-rate CD (> 1 year) 210 3.1
Physical capital 230 Equity 350
Total 1190 Total 1190
What will be the change in net interest income at the year-end if interest rates
fall by 1 per cent, from 5 to 4 per cent? Explain using income gap analysis.
(Use the following assumptions on the runo↵ of cash flows: fixed-rate mortgages
repaid during the year: 20 per cent; proportion of savings deposits and variable
rate CD that are rate-sensitive: 20 per cent).
(4 marks)
Reading for this question
See subject guide, Chapter 6, pages 125–7.
Approaching the question
i. To determine the amount of rate-sensitive assets:
– Commercial loans £560
– Fixed-rate mortgages (20% ⇥ 140) £28
– Variable-rate mortgages £260
= £848.
ii. To determine the amount of rate-sensitive liabilities:
– Money market deposits £350
– Savings deposits (20% ⇥ 280) £56
– Variable-rate CD (20% ⇥ 210) £42
= £448.
iii. What happens when interest rates decrease by 1%?
– Decrease in income on assets (= 1% ⇥ 848) £8.48
– Decrease in payments on liabilities (= 1% ⇥ 448) £4.48
– Decrease in net income £4.
(d) Calculate the duration gap for Bank Gamma.
(4 marks)
12
Examiners’ commentaries 2017
Reading for this question
See subject guide, Chapter 6, pages 129–30.
Approaching the question
Weighted asset duration:
= 8.1⇥ (260/1190) + 5.1⇥ (140/1190) + 3.5⇥ (560/1190) = 4.016 years.
Weighted liability duration:
= 1.9⇥ (350/840) + 2.3⇥ (280/840) + 3.1⇥ (210/840) = 2.33 years.
Duration gap:
= 4.0168 (840/1190)⇥ 2.33 = 2.3721 years.
(e) Explain why duration gap is likely to be positive for a bank.
(4 marks)
Reading for this question
See subject guide, Chapter 6, pages 129–30.
Approaching the question
As a bank is an intermediary then its maturity of assets > maturity of liabilities. As
maturity and duration are positively related then Duration assets > Duration liabilities.
Duration gap is e↵ectively:
Duration assetsDuration liabilities
which is therefore positive.
Question 7
(a) Consider the following stocks:
Stock X is expected to pay a dividend of £3 for the next two years and then
£4 forever;
Stock Y is expected to pay a dividend of £0.80, followed by £1.20 in year 2
then £1.40 in year 3 with dividend growth expected to be 3% per annum
thereafter.
If the required return on similar equities is 7%, calculate the price of each stock.
(6 marks)
(b) Discuss the issues with estimating future cash flows for a stock, government
bond and corporate bond.
(6 marks)
(c) Formally derive and discuss the dividend discount model used for the valuation
of common stocks.
(9 marks)
(d) Describe the Gordon growth model and identify the types of stocks it is best
used to value.
(4 marks)
13
FN1024 Principles of banking and finance
Reading for this question
See subject guide, Chapter 7, pages 150–5.
Approaching the question
(a) Price of X:
=
3
1.07
+
3
(1.07)2
+
4/0.07
(1.07)2
= £55.335.
(Note that stock X is valued as a perpetuity from year 3 on, then the perpetuity value is
discounted back to year 0 value.)
Price of Y:
=
0.8
1.07
+
1.2
(1.07)2
+
1.4
(1.07)3
+
1.4(1.03)/(0.07 0.03)
(1.07)3
= £32.37.
(b) Cash-flows generated from stocks are dividends, cash-flows generated from bonds are
interest. Stocks tend to be more volatile. Unlike bonds, which have contractual cash-flows
(interest and principal payments), common stocks have unspecified cash-flows. For
corporate bonds, there is additional uncertainty (compared to government bonds) because of
the higher risk of default.
(c) This is a formal derivation described in the subject guide. Start with the formula for the
expected return for a stock and re-work to a price formula. As this price formula has the
unknown price at the end of the next period we substitute for this consecutively until we
end up with price equal to the discounted value of dividends paid each period to infinity
plus the discounted terminal value of the stock at infinity. As the discounted value of the
stock at infinity is virtually zero we drop this term.
(d) The Gordon growth model is a pricing model for a stock based on the assumption of
constant growth of dividends to infinity. This assumption gives us a workable model of:
P0 =
D1
r g
where D1 = next period dividend, r = required return on equity and g = assumed constant
growth rate for dividends.
This model is best used for stocks that are mature and that pay dividends that grow
reasonably constantly. Examples include utility companies and supermarket companies.
Question 8
(a) Briefly explain each of the following terms:
i. ecient frontier
ii. feasible region
iii. security market line
iv. market risk premium.
(8 marks)
(b) Explain why, under the CAPM framework, the standard deviation of an asset’s
returns is not a good measure of risk.
(4 marks)
(c) Demonstrate how the capital market line can be identified by the introduction
of a risk-free asset.
(8 marks)
14
Examiners’ commentaries 2017
(d) Discuss the problems with empirically testing the Capital Asset Pricing Model.
(5 marks)
Reading for this question
See subject guide, Chapter 8, pages 164–75.
Approaching the question
(a) i. The ecient frontier is that part of the mean–standard deviation frontier that contains
portfolios that maximise return for a given level of risk. It runs from the minimum
variance portfolio to the maximum return portfolio.
ii. The feasible region represents all (feasible) combinations of N risky assets. It contains
inecient portfolios.
iii. The security market line lies in expected return–beta space and is the line of the CAPM.
iv. The market risk premium is the additional return earned over the risk-free rate for
exposure to market risk.
(b) It is assumed in the CAPM that investors are rational and have diversified away all their
specific risk. Hence they are only rewarded for market risk. The standard deviation is a
measure of total risk (i.e. specific + market risk). Hence not appropriate.
(c) The diagram illustrating the derivation of the capital market line is given below (and in the
subject guide). What this illustrates is that when an investor is faced only with risky assets
he is confined to the ecient frontier. With the introduction of a risk-free asset an investor
can invest in a combination of the risk-free asset and a risky portfolio on the ecient
frontier. The question is, which risky portfolio? To see this, draw a line from the risk-free
return to the ecient frontier, then increase the slope of the line until it is just tangential to
the ecient frontier. At the point of tangency is the optimal risky portfolio for all investors
and this line is called the capital market line.

(d) This question is focused on the problems of testing the CAPM and not the results from
empirical tests of the CAPM. The main problems with empirically testing the CAPM are
the following.
i. The market portfolio is unobservable – therefore return on the market cannot be
measured and a proxy must be used. Introduces error.
ii. On the left-hand side of the CAPM there is expected return and on the right-hand side
there is expected return on the market. Expected return is not known with certainty and
must be estimated. Hence introduces measurement error.
Better answers will discuss the consequences of these measurement errors for the estimation
of the CAPM.
15
FN1024 Principles of banking and finance
Examiners’ commentaries 2017
FN1024 Principles of banking and finance
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2016–17. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading
references
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
di↵erent editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.
Comments on specific questions – Zone B
Candidates should answer FOUR of the following EIGHT questions: ONE from Section A, ONE
from Section B and TWO further questions from either section. All questions carry equal marks.
Section A
Answer one question and no more than two further questions from this section.
Question 1
(a) Explain the process of securitisation and identify the advantages to a financial
institution in securitising its assets.
(10 marks)
Reading for this question
See subject guide, Chapter 3, pages 56–7.
Approaching the question
This question part requires two things: an explanation of the process of securitisation and
the identification of reasons why a financial institution such as a bank securitises its assets.
Many answers simply focused on an explanation of the process and did not cover advantages.
Securitisation is the process of transforming illiquid financial assets (such as loans and
mortgages) into marketable securities. Typically, this involves packaging illiquid loans into
bundles and then passing these on to a third party (special purpose vehicle (SPV)). The
SPV then manages the securitisation by issuing new (loan backed) securities to investors.
The original loans continue to earn interest which is typically passed through to the SPV to
16
Examiners’ commentaries 2017
pay the interest/capital on the issued securities. The SPV will pass the proceeds from the
sale of the securities back to the bank as cash.
In engaging in this process, the bank has therefore transformed illiquid loans into cash. This
allows it to manage liquidity risk over the medium/long term. It can also be used to remove
assets that have a high-risk weighting into assets with a lower risk weighting to help manage
its capital requirement.
Better answers would also identify the risks with securitisation.
(b) With reference to examples, discuss the characteristics and consequences of
financial bubbles in markets.
(15 marks)
Reading for this question
See subject guide, Chapter 3, pages 59–61.
Approaching the question
Financial bubbles are where prices of financial or real assets increase well above fair value
(fundamental) levels. There are typically three phases:
1. Rapid expansion of credit either from financial liberalisation or expansionary monetary
policy. Assets bought on credit – excess demand pushes up asset prices rapidly.
2. Asset prices collapse.
3. Increase in loan defaults. Banking crisis often follows.
Examples can be drawn from Tulip-mania, the internet bubble of the late 1990s or the
global banking crisis of 2007–08 which had at its heart a bubble in housing markets in the
U.S., U.K., Ireland, Spain etc. driven by relaxed monetary policy causing an increase in
credit expansion that fuelled house prices.
Question 2
(a) How does moral hazard influence the lending decisions of banks?
(7 marks)
Reading for this question
See subject guide, Chapter 4, page 73.
Approaching the question
Candidates need to first define moral hazard, i.e. the risk created by asymmetric
information after the loan is made because the borrower may use the loan for a riskier
proposition than promised, thus increasing the risk of default.
Moral hazard leads banks to reduce lending if not managed appropriately. Better answers
will explain that banks are able to manage moral hazard using restrictive covenants etc.
This leads to greater lending.
(b) Discuss how to reduce/solve the problems arising from adverse selection in the
lending process.
(13 marks)
Reading for this question
See subject guide, Chapter 4, pages 75–6.
Approaching the question
Adverse selection is a problem caused by asymmetric information before the loan is made,
which leads to a greater risk of default due to loss of better risks in the market.
17
FN1024 Principles of banking and finance
Solutions include:
1. Screening/information production.
2. Government regulation.
3. Financial intermediaries – produce information but do not face the free-rider problem.
Better answers will describe each of these solutions and then explain why the optimal
solution is provided by financial intermediaries.
(c) Explain why loan contracts do not su↵er from free-riding problems in
information production compared to bonds.
(5 marks)
Reading for this question
See subject guide, Chapter 4, page 80.
Approaching the question
A good answer would refer to the fact that bank loans are private securities, not traded in
the open financial market.
Therefore, investors are not able to observe the bank and bid up the price of the loan to the
point where the bank makes no profit on the production of information.
Bonds in contrast are tradeable therefore bonds su↵er from free-riding.
Better answers would explain that as a consequence of lending through non-traded loans
banks have the incentive to devote sucient resources to solving adverse selection/moral
hazard problems because no other investors can extract benefits from this. Hence the bank
gets all the benefits.
Question 3
(a) Discuss the main changes to capital regulation introduced by Basel 3.
(15 marks)
Reading for this question
See subject guide, Chapter 5, pages 105–6.
Approaching the question
Basel 3 e↵ectively changes the numerator in the risk assets ratio by increasing the amount
and quality of capital that banks need to hold against risk-adjusted assets.
The key changes to capital are:
1. Common equity (defined as ordinary or common shares plus retained earnings) should
form a greater part of Tier 1 capital. There is a minimum common equity to
risk-weighted assets ratio of 4.5%.
2. Tier 1 equity (made up of common equity plus other more strictly-defined capital
instruments – mainly preferred stock) to risk-weighted assets must be greater than 6 per
cent (compared to 4 per cent under Basel 2).
3. Total capital (Tier 1 plus Tier 2 capital) to risk-weighted assets must be greater than 8
per cent (no change compared to Basel 2).
4. A capital conservation bu↵er equal to 2.5 per cent of risk-weighted assets and made up of
common equity. This bu↵er will allow banks to build up capital during ‘good times’
which can then be drawn on in times of financial stress.
5. In addition, national regulators will be able to impose an additional 2.5 per cent capital
bu↵er when credit growth is judged to be excessive and there is a build-up of
system-wide risk. This capital bu↵er can then be released during the downswing to
enable banks to continue lending.
18
Examiners’ commentaries 2017
6. National regulators will also have further discretion to increase capital requirements for
large systemically important banks (to address the too-big-to-fail problem discussed
above).
(b) Explain the key features of the safety net in the regulatory system for banks.
Discuss the problems caused by this safety net and the solutions to these
problems.
(10 marks)
Reading for this question
See subject guide, Chapter 5, pages 98–100.
Approaching the question
The key features of the safety net are:
1. Deposit insurance.
2. Lender of last resort supply of liquidity.
3. Capital support in times of crisis.
All of these create moral hazard. Candidates need to explain specific measures used by
regulators to counteract this. Better answers will explain that supervision is the main
general technique used by regulators to address moral hazard problems.
Question 4
(a) Distinguish between valuation, allocative and informational eciency in relation
to financial markets. Explain why allocative eciency depends upon the
existence of valuation and informational eciency.
(10 marks)
Reading for this question
See subject guide, Chapter 9, pages 184–5.
Approaching the question
Note this question part has two elements: first, distinguishing between di↵erent kinds of
eciency in financial markets and, second, explaining why allocative eciency depends
upon the existence of the other two types. Better answers will cover both elements.
A financial market is referred to as informational ecient when security prices fully reflect
all available information.
Informational eciency is a more specific form of the general valuation eciency, which
refers to whether the prices of the securities traded on a market reflect the true fundamental
(also termed intrinsic, or fair) value of the securities. Under valuation eciency, all prices
are always correct, and reflect market fundamentals. Therefore, the market price of a
security is the fair price, and has to be equal to the expected cash-flows from the security
using all relevant information.
Informational eciency is a more specific form of eciency than valuation eciency,
because it assumes that expectations are optimal forecasts using all available information,
but not that market prices reflect the fair value.
Valuation eciency and informational eciency are conditions for the achievement of the
most general eciency condition of financial markets: allocative eciency. This refers to
whether a market allocates productive resources to the most productive investments in
performing its main function of channelling funds from saver–lenders to spender–borrowers.
This requires asset prices to reflect accurately the discounted stream of future cash-flows the
asset is expected to generate over its existence. The price of an asset then acts as a signal
directing resources from savers into the firm securities yielding the highest returns and from
firms into the real assets yielding the highest returns.
19
FN1024 Principles of banking and finance
(b) Explain the empirical evidence on market over-reaction in the context of weak
and semi-strong form eciency.
(15 marks)
Reading for this question
See subject guide, Chapter 9, pages 195–6.
Approaching the question
Evidence on market over-reaction constitutes an anomaly related to earnings
announcements. Although empirical evidence generally confirms rapid adjustment to new
information (as shown in the evidence in favour of the semi-strong form eciency), recent
evidence shows that stock prices do not instantaneously adjust.
A definition of over-reaction should be provided: over-reaction to earnings announcements
means that stock prices adjust beyond the valuation suggested by new information
embodied in the unexpected earnings announcement.
Answers should then examine the empirical evidence that shows that adjustment to extreme
bad news takes several months: there is a market over-reaction and subsequent gradual
adjustment (see for example the evidence in Ball and Brown (1968), then confirmed by
Bernard and Thomas (1989)).
Better answers will describe the methodology and findings of the study by Bernard and
Thomas (1989). They calculate the Cumulative Abnormal Returns (CAR) for 10 portfolios
with di↵erent levels of unexpected good or bad earnings over the years 1974–86. CARs are
measured for the pre- and post-announcement period. Portfolio 10 contains the 10 per cent
of the stocks with the highest earnings performance, portfolio 1 the lowest 10 per cent. As
shown in Bernard and Thomas (1989, p.10), portfolio 10 (extreme good news)
disproportionately increases its performance in the days immediately preceding the
announcement, and portfolio 1 (extreme bad news) disproportionately decreases its
performance. However, in the medium-long term after the announcement, the performance
of portfolio 10 decreases and the performance of portfolio 1 markedly increases. It seems
that there is an over-reaction before the announcement, and then the market needs
subsequent gradual adjustments to correct the over-reaction to the unexpected information.
As a consequence, investors could get excess returns by implementing a trading strategy: to
buy (sell) stocks immediately after the announcement of bad (good) news, and sell (buy)
them after several months when the price has risen (fallen) again. This trading strategy is
known as a contrarian strategy. The possibility to implement a contrarian strategy
profitably in such a framework is inconsistent with semi-strong form eciency.
Section B
Answer one question and no more than two further questions from this section.
Question 5
A firm is considering investing in the following two mutually exclusive projects:
Year Yeti Zylo
0 260000 350000
1 120000 100000
2 140000 130000
3 100000 125000
4 170000 125000
(a) If the opportunity cost of capital is 9%, calculate the net present value (NPV)
for each project.
(4 marks)
20
Examiners’ commentaries 2017
(b) Calculate the net present value for each project for discount rates of 12% and
14%. Draw a diagram of NPV against discount rates of 9%, 12% and 14% and
identify the approximate internal rate of return (IRR) for each project (you
may give your answer as a range e.g. 5% to 5.5%).
(7 marks)
(c) Based on your results for (a) and (b) which investment project(s) should the
company invest in? Explain your decision.
(4 marks)
(d) Critically assess the usefulness of the internal rate of return criterion for
investment appraisal.
(6 marks)
(e) Explain why the additivity property of NPV is useful when selecting investment
projects where funds are limited.
(4 marks)
Reading for this question
The reading for all parts of this question can be found in the subject guide, Chapter 7, pages
142–9.
Approaching the question
(a) We have:
Yeti, Cn (1 + i)n Cn/(1 + i)n Zylo, Cn Cn/(1 + i)n
260000 1 260000 350000 350000
120000 0.9174 110091.74 100000 91743.11
140000 0.8416 117835.19 130000 109418.39
100000 0.7721 77218.34 125000 96522.93
170000 0.7084 120432.28 125000 88553.15
NPV 11140.88 36237.60
(b) We have:
Yeti, Cn (1 + 0.12)n Cn/(1 + 0.12)n Zylo, Cn Cn/(1 + 0.12)n
260000 1 260000 350000 350000
120000 0.8928 107142.85 100000 89285.71
140000 0.7971 111607.14 130000 103635.20
100000 0.7117 71178.02 125000 88972.53
170000 0.6355 108038.07 125000 79439.75
NPV 4389.95 11333.20
Yeti, Cn (1 + 0.14)n Cn/(1 + 0.14)n Zylo, Cn Cn/(1 + 0.14)n
260000 1 260000 350000 350000
120000 0.8771 105263.15 100000 87719.29
140000 0.7694 107725.45 130000 100030.77
100000 0.6749 67497.15 125000 84371.43
170000 0.5920 100653.64 125000 74010.03
NPV 13854.89 3868.44
I.e. IRR for Yeti ⇡ 11% and IRR for Zylo ⇡ 13.5%.
21
FN1024 Principles of banking and finance

-20000
-10000
0
10000
20000
30000
40000
9 12 14
IRR Yeti and Zylo
Yeti Zylo
(c) Only one project can be selected as they are mutually exclusive. Choose Zylo as it has the
highest NPV (at the cost of capital) and the highest IRR.
(d) The internal rate of return (IRR) is the rate at which the present values of the cash in-flows
associated with a project equal the cash investment. The calculated IRR of a project is
compared to a hurdle rate – where IRR > hurdle rate the project is accepted. Where the
hurdle rate is equal to the firm’s cost of capital then NPV and IRR should give the same
decision. However, there are exceptions to this and some other problems with the IRR
method.
• Reinvestment rate implicit in the IRR method is not compatible with well-functioning
capital markets.
• When choosing between mutually exclusive projects (i.e. the projects have to be ranked)
the IRR method may not always give the same decision as NPV.
• IRR may give no solution or multiple solutions.
(e) To begin the answer, the additivity property needs to be explained, i.e. NPV(X + Y) =
NPV(X) + NPV(Y).
Then go on to explain why it is useful for capital constrained firms – it allows us to select
the combination of projects that has the highest NPV whilst still satisfying the capital
constraint.
Question 6
(a) Compare income gap analysis with duration gap analysis as techniques for
managing interest rate risk for a bank.
(9 marks)
Reading for this question
See subject guide, Chapter 6, pages 125–30.
Approaching the question
Income gap analysis examines the cash-flow e↵ects of interest rate changes whereas duration
gap analyses the market value e↵ect of interest rate changes.
22
Examiners’ commentaries 2017
Better answers would examine how each of these techniques work in measuring the di↵erent
interest rate risk. Excellent answers would explain that they are both useful techniques for a
bank. Income gap analysis is focused on measuring net interest e↵ects of interest rate
changes – a liquidity risk measure. Duration gap is focused on market value changes of assets
and liabilities following interest rate changes – as the value of assets value of liabilities =
net worth (equity capital) then this examines the impact of interest rate changes on capital.
(b) Consider the following balance sheet of Bank Leppa:
Assets ($) Duration Liabilities ($) Duration
Variable-rate
mortgages 250 7.5 Money market deposits 300 1.9
Fixed-rate
mortgages 120 4.1 Savings deposits 250 2.2
Commercial
loans 500 4.5 Variable-rate CD (> 1 year) 210 3.0
Physical capital 200 Equity 310
Total 1070 Total 1070
What will be the change in net interest income at the year-end if interest rates
rise by 1 per cent, from 3 to 4 per cent? Explain using income gap analysis.
(Use the following assumptions on the runo↵ of cash flows: fixed-rate mortgages
repaid during the year: 20 per cent; proportion of savings deposits and variable
rate CD that are rate-sensitive: 20 per cent).
(4 marks)
Reading for this question
See subject guide, Chapter 6, pages 125–7.
Approaching the question
i. To determine the amount of rate-sensitive assets:
– Commercial loans $500
– Fixed-rate mortgages (20% ⇥ 120) $24
– Variable-rate mortgages $250
= $774.
ii. To determine the amount of rate-sensitive liabilities:
– Money market deposits $300
– Savings deposits (20% ⇥ 250) $50
– Variable-rate CD (20% ⇥ 210) $42
= $392.
iii. What happens when interest rates increase by 1%?
– Increase in income on assets (= 1% ⇥ 774) $7.74
– Increase in payments on liabilities (= 1% ⇥ 393) $3.92
– Increase in net income $3.82.
(c) Calculate the duration gap for Bank Leppa.
(4 marks)
Reading for this question
See subject guide, Chapter 6, pages 129–30.
Approaching the question
Weighted asset duration:
= 7.5⇥ (250/1070) + 4.1⇥ (120/1070) + 4.5⇥ (500/1070) = 4.315 years.
23
FN1024 Principles of banking and finance
Weighted liability duration:
= 1.9⇥ (300/760) + 2.2⇥ (250/760) + 3.0⇥ (210/760) = 2.30 years.
Duration gap:
= 4.315 (760/1070)⇥ 2.30 = 2.681 years.
(d) What is the estimated change in the value of equity (in $s) for Bank Leppa if
interest rates increase by 1% from 3 to 4%?
(4 marks)
Reading for this question
See subject guide, Chapter 6, pages 129–30.
Approaching the question
Change NW / A = Dur Gap ⇥ Change in i/(1 + i).
Change NW / A = 2.681 ⇥ 0.01/1.03 = 0.026.
Change NW = 0.026⇥ 1070 = $27.85, i.e. a fall in NW as i has gone up.
(e) Explain why duration gap is likely to be positive for a bank.
(4 marks)
Reading for this question
See subject guide, Chapter 6, pages 129–30.
Approaching the question
As a bank is an intermediary then its maturity of assets > maturity of liabilities. As
maturity and duration are positively related then Duration assets > Duration liabilities.
Duration gap is e↵ectively:
Duration assetsDuration liabilities
which is therefore positive.
Question 7
(a) Consider the following stocks:
Stock A is expected to pay a dividend of $2.50 for the next two years and
then $4 forever;
Stock B is expected to pay a dividend of $0.90, followed by $1.20 in year 2
then $1.50 in year 3 with dividend growth expected to be 4% per annum
thereafter.
If the required return on similar equities is 6%, calculate the price of each stock.
(6 marks)
(b) Discuss the issues with estimating future cash flows for a stock, government
bond and corporate bond.
(6 marks)
(c) Explain why capital gains is not included in the dividend discount formula for
the valuation of a stock.
(5 marks)
24
Examiners’ commentaries 2017
(d) Explain Macaulay duration and describe the main characteristics of Macaulay
duration in relation to bonds.
(8 marks)
Reading for this question
See subject guide, Chapter 6, pages 127–9 and Chapter 7, pages 150–5.
Approaching the question
(a) Price of A:
=
2.5
1.06
+
2.5
(1.06)2
+
4/0.06
(1.06)2
= $63.92.
Price of B:
=
0.9
1.06
+
1.2
(1.06)2
+
1.5
(1.06)3
+
1.5(1.04)/(0.06 0.04)
(1.06)3
= $68.67.
(b) Cash-flows generated from stocks are dividends, cash-flows generated from bonds are
interest. Stocks tend to be more volatile. Unlike bonds, which have contractual cash-flows
(interest and principal payments), common stocks have unspecified cash-flows. For
corporate bonds, there is additional uncertainty (compared to government bonds) because of
the higher risk of default.
(c) The best way to approach this question is to briefly show how the dividend discount model
is derived (given in the subject guide reference above) and then show that although capital
gains are not included in the final version of the model they are implicit in the model.
(d) Macaulay duration is a weighted average maturity of a bond where the weights are the
relative discounted cash-flows.
Characteristics of Macaulay duration:
• Macaulay duration increases with the maturity of a bond.
• Macaulay duration decreases as the market interest rate increases: higher rates discount
later cash-flows more heavily, and the weights of those later cash-flows decline when
compared to earlier cash-flows.
• Macaulay duration decreases as the coupon interest rate increases: the larger the
coupons, the more quickly cash-flows are received by investors and the higher the weights
of those-cash flows.
Question 8
(a) Briefly explain each of the following terms:
i. unsystematic (unique) risk
ii. minimum risk portfolio
iii. capital market line
iv. market risk premium.
(8 marks)
(b) Explain why, under the CAPM framework, the standard deviation of an asset’s
returns is not a good measure of risk.
(4 marks)
(c) Derive, using two fund separation, the capital market line.
(8 marks)
25
FN1024 Principles of banking and finance
(d) Explain whether a stock that sits above the security market line is undervalued
or overvalued. Explain how this under or over valuation is likely to be corrected.
(5 marks)
Reading for this question
See subject guide, Chapter 8, pages 164–75.
Approaching the question
(a) i. Unsystematic risk is the risk that is unique to the security and can be diversified away by
combining the security with other securities.
ii. The minimum risk portfolio is the portfolio on the ecient frontier that delivers the
minimum risk (standard deviation) – it is the turning point on the mean – standard
deviation frontier.
iii. The capital market line lies in expected return–standard deviation space and is derived
from two fund separation.
iv. The market risk premium is the additional return earned over the risk-free rate for
exposure to market risk.
(b) It is assumed in the CAPM that investors are rational and have diversified away all their
specific risk. Hence they are only rewarded for market risk. The standard deviation is a
measure of total risk (i.e. specific + market risk). Hence not appropriate.
(c) The diagram illustrating the derivation of the capital market line is given in the subject
guide. What this illustrates is that when an investor is faced only with risky assets he is
confined to the ecient frontier. With the introduction of a risk-free asset an investor can
invest in a combination of the risk-free asset and a risky portfolio on the ecient frontier.
The question is, which risky portfolio? To see this, draw a line from the risk-free return to
the ecient frontier, then increase the slope of the line until it is just tangential to the
ecient frontier. At the point of tangency is the optimal risky portfolio for all investors and
this line is called the capital market line.
(d) A stock will be undervalued if it sits above the security market line (SML), i.e. it earns a
return in excess of that predicted by the CAPM.
Undervalued stocks will be demanded by investors – excess demand will increase the price
(decrease the return) until the stock sits on the SML, i.e. the market is in equilibrium.
26